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DRAFT Valuation of Employee Stock Options Practice Note October 2006

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DRAFT Valuation of Employee Stock Options Practice Note October 2006 DRAFT Valuation of Employee Stock Options Practice Note October 2006 Introduction This practice note has been prepared by the Stock Options Task Force of the Pension Practice Council of the American Academy of Actuaries.1 Our primary purpose is to provide guidance to actuaries and others performing valuations under the Financial Accounting Standards Board’s (FASB’s) Statement of Financial Accounting Standard (FAS) Number 123, Share-Based Payments, as amended in December 2004 (FAS 123R). The guidance provided in this practice note is intended to assist actuaries in the evaluation and selection of valuation methodologies, the selection of actuarial assumptions, and the documentation and reporting of the results of stock option valuations and related analyses. It is not a definitive statement of generally accepted practice in this area, and it has not been promulgated by the Actuarial Standards Board. This guidance is not binding on any actuary. It is important to note that the determination of fair value is the responsibility of the issuing company, and actuaries provide the company with recommended assumptions, models, and calculations. FAS 123R and the Security and Exchange Commission’s (SEC) Staff Accounting Bulletin (SAB) 107 provide detailed guidance on setting assumptions and selecting models. This practice note is not intended to supplant these documents. The actuary should have a thorough understanding of these documents before making any recommendations to a client. The task force and the practice council recognize that other professions have made substantial contributions to the body of knowledge and to the development of option valuation models. We expect this to continue as this practice area attracts increasing attention from financial economists, mathematicians, investment specialists, and others. We offer the guidance included in this practice note as our contribution to this multi-disciplinary effort. Our desire is that the actuarial disciplines we identify in this practice note will be instrumental in promoting an environment of confidence, rigor, transparency, comparability and credibility to the valuation of employee stock options—whether the valuation work is done by actuaries or other professionals. Accordingly, we encourage other professions to consider the guidance as appropriate. 1 The American Academy of Actuaries is a national organization formed in 1965 to bring together, in a single entity, actuaries of all specializations within the United States. A major purpose of the Academy is to act as a public information organization for the profession. Academy committees, task forces and work groups regularly prepare testimony and provide information to Congress and senior federal policy- makers, comment on proposed federal and state regulations, and work closely with the National Association of Insurance Commissioners and state officials on issues related to insurance, pensions and other forms of risk financing. The Academy establishes qualification standards for the actuarial profession in the United States and supports two independent boards. The Actuarial Standards Board promulgates standards of practice for the profession, and the Actuarial Board for Counseling and Discipline helps to ensure high standards of professional conduct are met. The Academy also supports the Joint Committee for the Code of Professional Conduct, which develops standards of conduct for the U.S. actuarial profession. Valuation of Employee Stock Options Practice Note DRAFT – October 2006 The task force welcomes your comments and suggestions for additional questions to be addressed by this practice note. Please address all communications to Heather Jerbi, the Academy’s senior pension policy analyst ([email protected]). The members of the task force responsible for this practice note are as follows: Thomas S. Terry, chairperson, MAAA, FSA, FCA, EA; Terry Adamson; Glenn D. Bowen, MAAA, FSA, EA; Ted Buyniski; Charles D. Cahill, MAAA, FSA, FCA, EA; Wing Wing Chan, MAAA, FSA, FCA, EA; Don Delves; Carrie Duarte; Mark D. J. Evans, MAAA, FSA; Ron Gebhardtsbauer, MAAA, MSPA, FSA, FCA, EA; Liaw Huang, FSA, EA; Albert E. Johnson, MAAA, FSA, EA; Kenneth A. Kent, MAAA, FSA, FCA, EA; Emily K. Kessler, MAAA, FSA, FCA, EA; John A. Luff, MAAA, FSA, FCIA; John E. McArthur, MAAA, ASA; James McPhillips, MAAA, FSA, FCA, EA; John M. Miller, MAAA, FSA, EA; Nicholas P. Mocciolo, MAAA, FSA; John P. Parks, MAAA, MSPA, FCA, EA; Alan H. Perry, MAAA, FSA; Stacy Powell, MAAA, FSA, FCA; Nicholas C. Reitter; Larry H. Rubin, MAAA, FSA; Marcia S. Sander, MAAA, FSA; Sean P. Scrol, MAAA, FCA, ASA; Matthew J. Siegel, MAAA, FSA, EA; John T. Stokesbury, MAAA, FSA, FCA, EA; Scott M. Turner, MAAA, FSA, EA; James F. Verlautz, MAAA, FSA, FCA, EA; Aaron R. Weindling, MAAA, FSA, FCA, EA; Stephen E. Zwicker, MAAA, FSA, EA 2 Valuation of Employee Stock Options Practice Note DRAFT – October 2006 Table of Contents Table of Contents........................................................................................................................................ 3 Section 1: Background................................................................................................................................5 Q1. What is the meaning of “valuation” as used in this practice note?.................................................. 6 Q2. What guidance is available with respect to stock option pricing/valuation? ................................... 6 Q3. What characteristics should be considered in the selection of stock option valuation models?...... 7 Q4. What are the categories of stock option valuation models?............................................................. 7 Q5. What other assumptions must be set? .............................................................................................. 9 Section 2: Model Selection ....................................................................................................................... 10 Q1. What are the necessary considerations for model selection?......................................................... 10 Q2. What stock option features should be considered? ........................................................................ 10 Q3. What employee exercise behavior should be considered?............................................................. 11 Q4. What economic and stock return assumptions should be considered? .......................................... 11 Q5. How should significance and simplification factor into model selection? .................................... 12 Q6. What are risk-neutral valuation models? ....................................................................................... 12 Q7. What is the relationship between a pricing model and the required input assumptions? .............. 13 Q8. What are the steps in selecting a pricing model?........................................................................... 13 Q9. How are stock prices modeled? ..................................................................................................... 13 Q10. How is employee exercise behavior modeled?............................................................................ 14 Q11. What other variables are used in determining payoff and exercisability? ................................... 14 Q12. What is the impact of stock price path dependence? ................................................................... 15 Section 3: Model Review and Validation ................................................................................................. 17 Q1. Why is model validation important?.............................................................................................. 17 Q2. What steps can be taken to validate a model?................................................................................ 17 Q3. What situations necessitate a review of the selected model?......................................................... 17 Q4. What additional steps are needed if the model is changed?........................................................... 17 Q5. Is it an unreasonable result if the value of the employee options exceeds the company's net worth? ............................................................................................................................................................... 18 Section 4: Analysis of Historical Data...................................................................................................... 20 Q1. What historical data is typically collected and analyzed?.............................................................. 20 Q2. Why is it important to distinguish cancellation data from forfeiture data? ................................... 20 Q3. Should demographic data be collected?......................................................................................... 21 Q4. How should historical data be analyzed?....................................................................................... 21 Q5. How should historical exercise be weighted?................................................................................ 22 Q6. What modification to historical data may need to be considered? ................................................ 22 Section 5: Setting the Expected Volatility Assumption........................................................................... 24 Q1. What is the volatility assumption?................................................................................................
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